Description

Energy Assets (EA) owns and operates 110K gas meters for industrial and commercial (I&C) customers in the United Kingdom and 74K loggers that transmit I&C meter data to gas suppliers and consumers.  The company also owns 15K gas meters for residential customers and operates a small electrical metering business, but >90% of the company’s current value is in I&C gas, and this write-up will focus on that area.

The I&C gas meter business in the UK is a small niche within the business of delivering gas to consumers for heating and industrial use. There are three large metering owners including National Grid, a former monopoly, as well as EA and Smart Metering Systems (SMS). More than a dozen other providers are licensed to install and own I&C gas meters, and the economics of the business are attractive:  14% unlevered returns on installed meters whose very low churn rate (<1% annually) allows leverage that lifts returns on equity to >20%, and decent price insensitivity due to the fact that gas meter rent is just 1-2% of a customer’s gas bill.  But the UK government’s break-up of the National Grid monopoly has led to just two entrants garnering >90% of new installations.  At September 2014, EA had 97K installed I&C meters (we estimate that this has grown to 110K today), and SMS had 27K, and EA is installing at a rate of 25-30K/year.  The next largest I&C meter installer is Exoteric, which appears to be largely inactive.

Barriers to entry are created by the specialized engineering required for high-capacity gas meters as well as the risk aversion that causes gas suppliers to select the most trusted and experienced meter providers. To a gas supplier choosing between meter operators, saving 20% on 1.5% of a customer’s gas bill is not attractive if the gas meter fails to deliver data, or causes a gas leak with explosive consequences. This is especially true given the pass-through by the gas supplier of the meter rental to the end customer.

There is a significant and visible growth opportunity due to regulations that require all 600K large I&C gas meters in the UK to be updated to be able to send usage data every 30 minutes to suppliers and customers by 2019. If EA builds its portfolio of gas meters and loggers to 200K and 115K, respectively, then maintenance free cash flow per share will be £0.59 by 2019 (assuming no price increase on meter rentals). Applying a terminal FCF yield of 8% would imply a stock price of £7.37 in March 2019, generating a 1.6x ROI and 13% IRR from today’s £4.58 share price. If meter rents can increase with inflation, the market might pay a 6% FCF yield, which would imply a £9.83 share price in March 2019 and result in a 2.1x ROI and 21% IRR. This valuation ignores any profit from the company’s Siteworks business that designs and installs gas meters, which is presently very busy as a result of the 2019 mandate and may have post-2019 business to do, especially with the possibility of EA expanding into the electricity or water meter markets, which themselves might be an attractive use of capital.

Background

EA was founded in 2005 to take advantage of National Grid losing its monopoly on natural gas meter owndership. There are roughly 23M gas meters in the UK, of which 1.5M are in the I&C sector while the remainder are residential meters. In 2009, the UK’s Department of Energy and Climate Change (DECC) mandated that all meters that log more than 732 Mwh of gas per year (~50K meters) must be capable of transmitting usage data electronically by April 2014. The UK’s national gas regulator OFGEM ruled in 2010 that all I&C meters need to be upgraded by 2019, and EA’s addressable market includes the largest 600K of the 1.5M total. Many of the 600K meters have been replaced already or are new enough (installed after 2000) that they can meet the mandate by upgraded by having a logger attached to them. There is uncertainty about the number of meters yet to be replaced or upgraded, but EA management believes that about 200K meters will need to be replaced and fitted with a logger by 2019, and perhaps 100K meters will need to be upgraded with a logger. In July 2014, British Gas announced that it will split the replacement of ~120K meters 50/50 between EA and SMS. Suppliers yet to make a decision include E.ON, nPower, and Scottish Power, which in total seem likely to have at least 80K meters to replace or upgrade.

Note that EA’s present rate of 25-30K meter replacements per year includes 15-20K meters/year under exclusive contracts with Corona (owned by Macquarie, which owns 39% of EA’s shares) and Gazprom, and 10K meters/year under its 50% share of the British Gas contract.  Management will not disclose how many meters remain to be installed for Corona or Gazprom, but believes 200K meters by 2019 is realistic given current level of ~110K plus 60K for British Gas and likely wins with suppliers yet to decide.  In particular, the risk of a new entrant is low given the short time frame before the mandate is complete, and suppliers are unlikely to retain ownership, as discussed below.

The gas suppliers (including British Gas, Gazprom, Corona, and Total) bear the responsibility for upgrading meters and select which provider to use. The supplier then passes the £120/year rent for the meter along to its customers. Churn due to end consumers switching gas suppliers is roughly 10%/year, but Energy Assets has agreements with 80% of suppliers (by volume) to honor its meter contract with the customer’s prior supplier. Even in cases where EA does not have such an agreement, the new supplier tends to honor EA’s contract due to the high costs of buying and installing another meter. The total cost is ~£850, of which £650 is the meter (which the supplier would have to return to EA and buy a replacement for) and £200 to install. The motivation to choose a meter provider based on price is relatively weak since the meter rent is 1-2% of the total gas bill. For example, a gas price of 3 pence/kWh would imply a yearly gas bill of £15K for a meter logging 500 Mwh. Safety and reliability—rooted in engineering expertise—is far more important to customers than saving a few tenths of a percent from the total gas bill. The basic mechanism for gas meters has not changed in half a century, and EA’s 2012 IPO prospectus states that a “significant proportion” of the meters being used today are over 20 years old. Energy Assets is currently replacing the older meters with newer models that can transmit consumption data to suppliers and customers every half hour using a data logger. Once the new generation of meters is installed, it seems likely that the economic life will exceed the estimated useful life of 20 years used in accounting statements. This is why we value the business based on 2019 maintenance free cash flow rather than today’s net income.

Data loggers are required to use with replaced and updated meters, but the business for loggers is different than the business for meters in several ways. Loggers are not as relevant to safety or as expensive as meters are, the useful life of a logger is only 5-7 years, and loggers suffer from higher failure rates than meters. There is also more competition based on price. Consumers can choose cheaper loggers from SMS for £30/year that transmit raw data. EA offers a £120/year data service direct to consumers that includes a value-added data including local climate conditions, the BTU content of the gas consumed, and comparisons with other sites (40% of EA’s loggers), or will send raw data to the supplier for £45-60/year (60% of EA’s loggers).

CEO Philip Bellamy-Lee and COO Russell Gibson each have over 30 years of experience in the gas industry, and calls to customers and competitors show industry respect for them.  Typical commentary suggests that EA is well-engineered, and SMS is commercially aggressive. Philip and Russell also own stock and options worth about 3x their annual respective salaries at a £4.58 share price. The shareholder base is concentrated with Macquarie owning 39% of the company and several value investors owning ~20%. Macquarie bought EA during the financial crisis when it lost access to its line of credit. Macquarie was already closely tied to EA at the time, since most of EA’s meter portfolio at the time was used by Corona’s customers. Since Energy Assets went public in 2012 the client base has been diversified and Macquarie has been selling its stake, although it has refused to sell recently, possibly because of the British Gas deal.  In 2012, 48K of EA’s 63K gas meters were sourced from Corona, or 76%.  During the fiscal year ended March 2014, 37% of EA’s revenues were from Corona, and this has likely fallen further due to (i) the British Gas deal and (ii) customer churn away from Corona to other gas suppliers.

Risks

The biggest risks appear to be execution on the growth strategy, disruption in the meters and logger businesses, and the issue of capital allocation at the end of the growth runway.

Management expects to add 25-30K new large I&C meters per year on top of a current base of 110K, which is faster than the 16-20K/year growth rate that EA has experienced since 2011. This risk is mitigated by the visibility of the 60K meter contract with British Gas and the exclusive agreements in place with Corona and Gazprom. Disruption in the business could be in the form of tougher pricing competition from SMS or others which have not yet emerged, or gas suppliers that decide to provide meters in-house. The first two forms of disruption seem unlikely given the barriers to entry, and the short time frame remaining. Gas suppliers considering keeping their meters on-balance sheet have to deal with customer churn, which means ~10% of meters transitioning to another supplier each year.  Despite the attractive returns on capital, the remaining gas suppliers seem unlikely to want to spend £68 million (£850/meter for 80K meters) in order to own 1-2% of their revenue stream that will end up requiring that they service their competitors over time.

Regulatory disruption could take the form of OFGEM, DECC, or Parliament changing gas meter requirements or deadlines as well as imposing price controls on the meter industry. The former seems unlikely since this is an example of smart public policy, as updated meters cost 1-2% of the gas bill and seem likely reduce energy usage by more than 2%. Price controls would be contrary to the goals of encouraging private competition with the former National Grid monopoly. Evidence of this encouragement is the July 2014 equal division of British Gas’s 120K meters, currently with National Grid, between EA and SMS. In 2010, National Grid was also fined £15M for anticompetitive behavior in the much larger domestic meter market.

A risk that will be relevant in several years is the issue of capital allocation at the end of the growth runway in 2019. Capital expenditures are roughly equal to sales currently, and management will need to be more thoughtful about capital allocation once the land grab is over. Management’s choice between investment in other metering businesses for water and electricity versus return of capital would be better made if they owned more stock.

A final risk is a spike in interest rates, which could reduce the attractiveness of EA’s recurring  cash flows once the meters and loggers are built out.

Valuation

The investment thesis is based on the ability for Energy Assets to increase the size of its meter and logger portfolio by making investments with very attractive rates of return. The meters cost £850 to install and then generate £120/year of rent for over 20 years with minimal maintenance expense. This generates unlevered returns of 14% and, when financed with 80% debt, produces returns on equity >20%. The economics of loggers are similarly attractive with a cost of £120, average rental income of £80/year, and a lifetime of 5-7 years. The churn and pricing competition is higher for loggers than for meters, but logger costs are declining due to the deflation of prices for electronic goods and cellular data services.

We can measure the attractiveness of Energy Assets in the case with and without the growth expected to occur by the regulatory deadline. We will also be conservative and ignore contributions from the Siteworks segment which occur only when engineers help install new meters and thus have a lower quality of earnings than the Meter Asset Management (MAM) and Automated Meter Reading (AMR) segments (ie, meters and loggers). The table below shows the operating results expected for the year ending March 31, 2015 and forecasts results for the year ending March 31, 2019 based on growth expectations.

If EA’s portfolio experienced no more growth after March 31, 2015, the 110K meters and 74K loggers would generate annual free cash flows after maintenance capital expenditures of £8.9M. For 27.5M shares outstanding this is £0.32/share of maintenance FCF, representing a 7.0% yield on today’s share price of £4.58. EA’s contracts with Corona and Gazprom also stipulate annual price negotiations, and the terms with British Gas allow meter rents to track inflation. This means that if inflation in the UK resumes at 1-2% over the long term, an investor who bought EA today and held it forever would achieve annual returns between 7% and 9% if management simply administered the meter and logger portfolio at its current size. This 7-9% IRR at today’s £4.58 share price is locked in by long-term contracts and thus represents a bear case, as the likely growth involving >20% returns on equity would clearly enhance this return.

The expected growth of 20-30K meters/year and 10K loggers/year (shown in the table above) implies that EA’s portfolio will produce annual free cash flows after maintenance capital expenditures of £17.4M by 2019. On an estimated 29.5M shares outstanding in 2019, this is £0.59/share of maintenance FCF. If the execution of this growth is successful, investment returns will vary depending on EA’s ability to increase meter rents at or faster than the rate of inflation. The results in the cases with and without pricing power are shown in the table below.

We estimate an 8% FCF yield in 2019 if EA cannot increase rents at the rate of inflation. This would generate a 13% IRR based on today’s share price. This seems pessimistic, however, given that EA’s contracts with British Gas allow rents to track inflation and that Corona and Gazprom (both relatively insensitive to meter rent prices in our view) will renegotiate prices annually with EA. If meter rents do increase with inflation, then the market may pay a 6% FCF yield. This would generate a 21% IRR for the next four years if management executes on the growth described above.

Note that management is confident of its ability to negotiate price increases to keep up with inflation.  Over the past three years, Corona has agreed to one price increase, and management believes that costs have not been growing enough in a low inflation environment to justify pressing for annual increases.

Note that this analysis ignores lower-quality earnings derived from EA’s domestic meters (roughly 15K today), the Siteworks segment (generating an incremental £2.0M of net income in 2015), and EA’s BGlobal Metering subsidiary that serves the I&C electricity meter market. Successful entrance into electric and water metering could drive additional upside, and there is some logic to EA succeeding in those sectors given customer relationships, engineering skill and synergy from combining data on use of multiple commodities.

Catalyst

Management continues to install meters and loggers at rates and IRRs projected.